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RICS Professional Guidance, UK

1st edition, guidance note

GN 101 /2013

Construction security andperformance documents

Part of the QS & Construction Standards

Construction security and performancedocumentsRICS guidance note

1st edition (GN 101/2013)

Acknowledgment

Acknowledgment

Cover image © iStockphoto/tools to work (image no. 7829495)

Published by the Royal Institution of Chartered Surveyors (RICS)

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ISBN 978 1 78321 000 8

© Royal Institution of Chartered Surveyors (RICS) May 2013. Copyright in all or part of this publication rests with RICS. No part of thiswork may be reproduced or used in any form or by any means including graphic, electronic, or mechanical, including photocopying,recording, taping or Web distribution, without the written permission of the Royal Institution of Chartered Surveyors or in line with the rulesof an existing license.

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ii | CONSTRUCTION SECURITY AND PERFORMANCE DOCUMENTS

Contents

Acknowledgments iv

RICS guidance notes 1

Introduction 3

1 General principles (Level 1 – Knowing) 4

1.1 Introduction 41.2 Parties to a project 61.3 Interested third parties 81.4 Construction security and performance documents 9

2 Practical application (Level 2 – Doing) 16

2.1 Introduction 162.2 Parent company guarantees 162.3 Bonds 172.4 Collateral warranties 202.5 Third party rights 222.6 Direct agreements 232.7 Payment security methods 24

3 Practical considerations (Level 3 – Doing/Advising) 26

3.1 Introduction 263.2 Parent company guarantees – items for consideration 263.3 Bonds – items for consideration 273.4 Collateral warranties – items for consideration 293.5 Third party rights – items for consideration 323.6 Collateral warranties/third party rights and latent defects insurance 333.7 Direct agreements – items for consideration 333.8 Payment security methods – items for consideration 34

CONSTRUCTION SECURITY AND PERFORMANCE DOCUMENTS | iii

Acknowledgments

RICS would like to thank the following for their contributions to this guidance note:

Technical author

Kevin Greene (K&L Gates LLP)

Black Book Working Group

Chair: Andrew Smith (Laing O’Rourke)

John G Campbell (BAM Construction Limited)

David Cohen (Amicus Development Solutions)

Stuart Earl (Gleeds Cost Management Limited)

Christopher Green (Capita Symonds Ltd)

Jim Molloy (Department of Health, Social Services and Public Safety NI)

Roy Morledge (Nottingham Trent University)

Michelle Murray (Turner & Townsend plc)

Alan Muse (RICS, Director, Built Environment Professional Group)

Michael T O’Connor (Carillion Construction Limited)

Kevin Whitehead (McBains Cooper Consulting Limited)

RICS would also like to recognise the assistance of the following members of K&L Gates LLP in thedrafting of this guidance note:

Cathy Harris

Laura Ludlow

Jamie Olsen

David Race

iv | CONSTRUCTION SECURITY AND PERFORMANCE DOCUMENTS

RICS guidance notes

This is a guidance note. Whererecommendations are made for specificprofessional tasks, these are intended torepresent ‘best practice’, i.e. recommendationswhich in the opinion of RICS meet a highstandard of professional competence.

Although members are not required to followthe recommendations contained in the note,they should take into account the followingpoints.

When an allegation of professional negligenceis made against a surveyor, a court or tribunalmay take account of the contents of anyrelevant guidance notes published by RICS indeciding whether or not the member had actedwith reasonable competence.

In the opinion of RICS, a member conformingto the practices recommended in this noteshould have at least a partial defence to anallegation of negligence if they have followedthose practices. However, members have theresponsibility of deciding when it isinappropriate to follow the guidance.

It is for each member to decide on theappropriate procedure to follow in anyprofessional task. However, where members donot comply with the practice recommended inthis note, they should do so only for a goodreason. In the event of a legal dispute, a court

or tribunal may require them to explain whythey decided not to adopt the recommendedpractice. Also, if members have not followedthis guidance, and their actions are questionedin an RICS disciplinary case, they will be askedto explain the actions they did take and thismay be taken into account by the Panel.

In addition, guidance notes are relevant toprofessional competence in that each membershould be up to date and should haveknowledge of guidance notes within areasonable time of their coming into effect.

This guidance note is believed to reflect caselaw and legislation applicable at its date ofpublication. It is the member’s responsibility toestablish if any changes in case law orlegislation after the publication date have animpact on the guidance or information in thisdocument.

It is the member’s responsibility to be aware ofchanges in case law and legislation since thedate of publication.

Document status defined

RICS produces a range of professionalguidance products. These have been defined inthe table below. This document is a guidancenote.

CONSTRUCTION SECURITY AND PERFORMANCE DOCUMENTS | 1

Type of document Definition StatusStandardInternational Standard An international high level principle based

standard developed in collaboration withother relevant bodies

Mandatory

Practice StatementRICS practicestatement

Document that provides members withmandatory requirements under Rule 4 of theRules of Conduct for members

Mandatory

GuidanceRICS Code of Practice Document approved by RICS, and endorsed

by another professional body/stakeholderthat provides users with recommendationsfor accepted good practice as followed byconscientious practitioners

Mandatory orrecommended goodpractice (will beconfirmed in thedocument itself)

RICS Guidance Note(GN)

Document that provides users withrecommendations for accepted goodpractice as followed by competent andconscientious practitioners

Recommended goodpractice

RICS InformationPaper (IP)

Practice based information that providesusers with the latest information and/orresearch

Information and/orexplanatory commentary

2 | CONSTRUCTION SECURITY AND PERFORMANCE DOCUMENTS

Introduction

This guidance note reviews security andperformance documents normally associatedwith a construction project. In general terms,these are documents required as security forperformance of one sort or another (whetherpayment, design, management or construction)in a project. In complex projects, there may bemany different types of security andperformance documents required by severalparties.

This guidance note will review the main typesof security and performance documents, theparties to them, their purpose and generalterms. It begins with a discussion of thegeneral principles (Level 1 – Knowing), isfollowed by a review in more detail of thenature and purpose of construction securityand performance documents (Level 2 – Doing)and ends with a consideration of practicalmatters that can arise (Level 3 – Doing/Advising).


1 General principles (Level 1 – Knowing)

1.1 Introduction1.1.1 Many construction projects, no matterwhat their size, have a potentially complexstructure of contractual relations and multipleparties. The payment paths can be wide-ranging – from employers to contractors andfrom contractors down the supply chain tosub-contractors and suppliers. Cash flow is thelife blood of the construction industry andkeeping payments flowing is essential. Theperformance of payment obligations on allsides is, therefore, of fundamental importanceand involves a consideration of how suchperformance can best be secured and risks ofnon-payment minimised as far as possible.

1.1.2 The employer may enter intodevelopment and funding obligations with thirdparties, such as funders, purchasers andtenants. Many employers receive funding fromdifferent sources, such as banks and buildingsocieties. These funders will require‘construction security’ documents to be inplace to help protect their loans and beforethey will release funds. The project may be letor sold (before, during or after construction) topurchasers and tenants. When taking aninterest in a new, recently built or recentlyrefurbished property, such purchasers andtenants will also want construction security.Funders, purchasers and tenants are likely torequire a contractual connection with thoseresponsible for the design and construction ofthe project in order to protect their position.This would be necessary, for example, in theevent of defects manifesting themselves at alater date after occupation or acquisition bytenants or purchasers, or if funders wish tostep into the position of the employer if theemployer becomes insolvent or otherwisedefaults. In the absence of such a contractualconnection, it is unlikely that these third partieswould be able successfully to claim againstparties responsible for the defect or, in the

case of a funder, to step into the position ofthe employer in order to complete the project.

1.1.3 A contractual connection is requiredbecause a basic rule of contract law is thedoctrine of ‘privity of contract’. This doctrineprovides, as a general principle, that only aparty to a contract can take the benefit of thatcontract. Many parties are involved in thedesign, management and construction processand an employer will almost always enter intoformal, written contracts with the members ofits design and management team and thecontractor employed to carry out the works.These contracts will deal with the services andworks the team and the contractor are requiredto carry out, how they are paid and so on.Third parties (such as funders, purchasers andtenants) do not enter into these contracts(indeed some of these third parties may noteven be identified at the time such contractsare entered into). However, if a consultant orcontractor makes a mistake during design orconstruction, and a defect in the completedbuilding arises as a result, a funder, purchaseror tenant might suffer financial loss (e.g. thecost of rectifying the defect, the cost of findingalternative accommodation while the defect isrectified, loss of interest and rental income,etc.).

In general terms, the doctrine of privity ofcontract means that, in the absence of anycontract with those responsible for a mistake,the funder, purchaser or tenant, would not beable successfully to claim in contract torecover such loss. Further, as the law currentlystands, it would be very difficult (if notimpossible) for a funder, purchaser or tenant torecover their losses from the consultants andcontractor on a ‘non-contractual’ basis, suchas under the law of tort (essentially negligence).

Figure 1(a) illustrates the doctrine of privity ofcontract.


1.1.4 A collateral warranty (sometimes alsocalled ‘a duty of care deed’) has been, andremains, one of the ways of overcoming thesedifficulties. A collateral warranty is a bindingcontract between a third party with an interestin the project under construction or in thecompleted project (such as a funder, purchaseror tenant) and a party who was involved in thedesign, management and/or construction of theproject. A collateral warranty would allow athird party to make a claim against, forexample, a structural engineer, if the engineer’sdesign fell below a required standard of skilland care and/or a contractor, if the buildingwas built defectively. In order for any claim tobe successful under a collateral warranty, as inany contractual claim, the third party wouldhave to show that it suffered loss as a result ofthe defective design and/or workmanship.

Figure 1(b) shows, in simple terms, the use of acollateral warranty.

1.1.5 The general rule under the doctrine ofprivity has been fundamentally changed by theContracts (Rights of Third Parties) Act 1999 (theTPR Act). In short, the TPR Act provides that a

third party (such as a funder, purchaser ortenant) may in its own right enforce a term, orterms, of a contract if such contract expresslyprovides that it may do so or purports toconfer such a benefit on it. In this manner, suchthird party rights allow a third party to make aclaim against any consultant or contractor fordefective design and/or workmanship in muchthe same way as under a collateral warranty. Inthe example set out in paragraph 1.1.4, thethird party would be able to make a claimagainst the structural engineer and/or thecontractor, even in the absence of a collateralwarranty, provided that the structural engineer’sappointment and building contract effectivelyprovided that the third party could, in its ownright, enforce the terms of such appointmentand contract. In other words, the third partycan, in those circumstances, take the benefit ofthe terms of a contract even in the absence ofa direct contractual link (the TPR Act therebycreating an exception to the privity of contractdoctrine). Figure 1(c) illustrates the use of thirdparty rights. While third party rights are beingincreasingly adopted in UK developmentprojects, collateral warranties are still widely


used. This balance, however, is changing asthe construction industry becomes morefamiliar, and comfortable, with third partyrights.

1.2 Parties to a projectA development project often comprises thefollowing parties:

+ funders

+ employers/developers

+ professional consultants, such asarchitects, engineers (structural andmechanical and electrical), quantitysurveyors, cost consultants, CDM co-ordinators and project managers.Sometimes this team will be augmented byspecialist consultants, such as acousticconsultants and sustainability consultants

+ contractors; and

+ sub-contractors.

1.2.1 Funders

(a) Funders are parties who lend money inconnection with a project, usually banks,building societies or other similar fundinginstitutions. However, certain institutionalinvestors, such as pension funds or lifeassurance companies, fund projects and aretypically referred to as ‘funds’. An employer(likely to be referred to as a developer) and afund of this nature may exchange contracts forthe sale of the completed property at an earlystage of the development process (such aswhen the works are partially complete or evenbefore they have started), a so-called ‘forwardpurchase’. The fund does not agree to provideconstruction finance but will pay the purchaseprice when the project is completed. Incontrast, certain funds may (in what is knownas a ‘forward funding’ arrangement) providefinance to the employer to cover the cost ofthe project as it progresses during thedevelopment phases (including the costs of thecontractor and the consultants). In such anarrangement, the fund is likely to purchase theland at the outset, before developmentcommences. For the purposes of this guidancenote, funders are parties (such as banks and

building societies) who lend money in the moretraditional bank lending sense, although thefunds in forward purchase and forward fundingtransactions may also require constructionsecurity documents similar in nature to thoserequired by funders.

(b) Funders will want to be comfortable thattheir involvement will be satisfactory from afinancial point of view but also that, if mattersdo not go according to plan, they are as wellprotected as possible.

(c) There is likely to be a lengthy facility, orfunding, agreement between the funder and theemployer (the borrower). The funder will beconcerned to cover the position where theemployer gets into financial difficulties. The riskof contractor, principal sub-contractor orconsultant insolvency is normally left with theemployer.

(d) If there is an employer default (financial orotherwise), a funder will wish to havearrangements in place from the outset thatenable it to take over the project itself, orthrough an appointed third party withcomparable skills to the employer, in order tocomplete it (sometimes referred to as ‘buildingit out’). This is to achieve completion of theproject with the minimum of extra expense,disruption and delay that will inevitably occur inthese circumstances.

1.2.2 Employers

(a) The employer is the party for whose benefitthe project is carried out. An employer is oftenreferred to as a client, developer or promoter,depending on the context.

(b) The employer will (with relevant members ofits team) appoint the consultants, choose thecontractors, agree the terms of the buildingcontract (including the contract sum) and thenarrange for these parties to be paid.

(c) The employer is particularly interested toensure that the project succeeds – that costscome within budget and that the project meetsexpectations relating to quality, health andsafety and programme. The employer maywant to let and/or sell the completed project (inwhole or in part) and it may have borrowedmoney from funders to pay for the works. The


employer will want to ensure that all third partysecurity and performance documents are inplace (or can be put into place) so that theconditions of any letting, sale and funding aresatisfied. It will also want to ensure that itsposition is protected in the event of any seriousdefault by anyone in the contractual supplychain, particularly the main contractor.

1.2.3 Professional consultants(a) The primary roles of the professionalconsultants engaged by the employer are todesign, cost, manage and administer thecontracts and the project. They also carry outservices relevant to statutory responsibilities,such as obtaining planning consents for theemployer and ensuring compliance with healthand safety regulations.

(b) The employer may be entering into formal,written appointments with each of theconsultants. These appointments are likely tobe based on those published by the relevantbody governing the profession of theconsultant (such as RICS, RIBA and ACE) or tobe in a bespoke form, i.e. drafted by or onbehalf of the employer and tailored for theparticular requirements of the project. Theseappointments will usually include, for example,an obligation upon the consultant to providecollateral warranties and/or third party rights tothird parties, such as funders, purchasers andtenants. In some projects, funders willseparately appoint independent technicalmonitors to deal with payments and to checkthat the project is being carried out properlyand not over-running in terms of cost and time.These monitors will generally be professionalconsultants who will work alongside theconsultants appointed by the employer.

1.2.4 Contractors(a) The contractor agrees to carry out thebuilding works in accordance with the drawingsand/or specifications and the terms of thebuilding contract agreed with the employer.They may do so themselves or (more usually)employ sub-contractors to carry out some orall of the works. The contractor will beresponsible for managing and monitoring thesub-contractors and (as a general rule) for theirperformance.

(b) The contractor may agree to construct theworks in accordance with the design producedby the employer and/or their professionalconsultants – the so-called ‘traditional’ methodof procurement. This is illustrated by Figure 2.

(c) Alternatively, the contractor may agree totake on design responsibility under the buildingcontract – the so-called ‘design and build’method of procurement. This is illustrated byFigure 3.

(d) There are other procurement methods butthis guidance note concentrates on the typesmore frequently used. The general principles,however, can be carried through where othermethods of procurement are adopted.

(e) The employer will most likely enter into aformal, written building contract with thecontractor which reflects the chosen method ofprocurement. The contract may (as with theconsultants’ appointments) be in a standardform, such as those published by the JCT orNEC, or may be bespoke (probably anamended standard form) to reflect therequirements of the project.

1.2.5 Sub-contractors

(a) Main contractors will generally employ sub-contractors to undertake some or all of thedesign and/or construction of the works. Themain contractor will usually take responsibilityfor the works of their sub-contractors as if they


had carried out the works themselves, but theemployer and third parties (such as funders,purchasers and tenants) will most probablylook for performance security from the maindesign sub-contractors in the event that themain contractor defaults or becomes insolvent.

(b) The sub-contractors may enter into formal,written sub-contracts with the main contractor.These may be in a standard form (such as theJCT and NEC forms) or an amended standardform. The sub-contract will usually be a ‘flowdown’ of the relevant obligations placed uponthe main contractor. For example, if the maincontractor has to obtain collateral warranties orthird party rights from certain sub-contractorsin favour of third parties, this obligation shouldbe passed down by the main contractor tothose sub-contractors by way of inclusion inthe relevant sub-contracts.

(c) There may be specialist suppliers who arecontracted to supply goods and materials tothe contractor and/or sub-contractors, such asductwork and cladding suppliers. It would beunusual to have collateral warranties or thirdparty rights from such suppliers as

responsibility for their goods and materials isusually assumed by the contractor or sub-contractor incorporating them into their works.There may, however, be product guaranteesand warranties relating to the quality of suchgoods and materials given by the supplier,which are available to the owner of thecompleted project. Such product guaranteesand warranties are not discussed in thisguidance note.

1.3 Interested third parties

An employer will often finance the project withoutside funds. An employer may wish todevelop the project for their own use or with aview to selling and/or letting it (or parts of it).Such funders, purchasers and tenants all havean interest in the outcome of the project. Forthe purposes of this guidance note, they willgenerally be referred to as ‘interested thirdparties’ or ‘interested third party beneficiaries’.

Figure 4 illustrates the inter-relationshipbetween various interested third parties on


traditional and design and build procurementmethods in a typical project.

1.4 Construction security andperformance documents

1.4.1 General

(a) When taking an interest in a constructionproject, interested third parties usually requiresome form of construction security. Thissecurity may be available over, or alongside,the rights to enforce some of the terms of thecontracts between the employer and thosewho are designing, managing and/orconstructing the project. It may allow a partywith an interest in the project to exercise rightsthat they would not otherwise have. Forexample, it is specifically in relation to the areaof employer default that potential problemsarise for a funder in funding a project. In orderto safeguard the investment a funder hasmade, the funder will want to have in placearrangements that enable them, in the event ofserious default by an employer, to take over thewhole project themselves, or possibly through

an appropriately qualified third party appointedby the funder. This is to ensure that they canbuild out and secure completion of the projectwith the minimum of disruption and delay (andextra cost). Such arrangements are usuallycalled ‘step-in rights’. In effect, these rightscreate an express contractual right for thebenefit of the funder, and form part of theirsecurity package for the loan to the employer.

(b) In addition, credit risk in the constructionindustry is high, particularly as the constructionsupply chain often operates on unsecuredcredit. It may be necessary, therefore, toconsider the manner in which insolvency risks(of the employer as well as the members of thesupply chain) can be dealt with.

(c) Construction security and performancedocuments typically used in a constructionproject are:

+ parent company guarantees

+ bonds

+ collateral warranties

+ third party rights

+ direct agreements; and

+ payment security methods (such as escrowaccounts and project bank accounts).


(d) Figure 5 illustrates the relationship betweenvarious parties on a typical project providing orreceiving the benefit of parent companyguarantees, bonds and direct agreements.Figures 6a and 6b illustrate typicalarrangements between various parties giving or

receiving the benefit of collateral warranties orthird party rights. Each project will havedifferent requirements; it is not possible, withinthis guidance note, to examine all of thedifferent permutations of the securitydocuments that might be used.

1.4.2 Bonds and guarantees – anintroduction

(a) It is important to understand basic legalprinciples relating to bonds and guarantees,which are forms of security often used in theconstruction industry. Bonds and guaranteeshave much in common but there can be adegree of misunderstanding about what eachtype of security is intended to achieve. This isnot least because of the numerous descriptionsgiven to them, such as ‘on demand bond’,‘conditional bond’, ‘default bond’, ‘guarantee’,‘performance bond’ and ‘parent companyguarantee’. The description of the documentitself may not be conclusive of the type of legaleffect it actually has. Issuers of bonds andguarantees are variously described as‘obligors’, ‘bondsmen’, ‘sureties’ or

‘guarantors’. For the purposes of this guidancenote, they are referred to as bondsmen orguarantors. Those receiving the benefit ofbonds and guarantees are often called‘obligees’ or ‘beneficiaries’. They will bereferred to as beneficiaries within this guidancenote.

(b) It is important, in this context, to make adistinction between primary and secondaryobligations:

+ A primary obligation is (in the context of abond or guarantee given to an employer) anundertaking from a bondsman to pay a sumof money to the employer without referenceto the liability of the contractor. An exampleis where A promises to pay B up to £1million if B (simply) asks A to do so, inwriting. This is in the nature of an ‘on


demand’ bond. The more commonly usedtype of on demand bonds in the UK areadvance payment, tender and retentionbonds (which are discussed at paragraph1.4.4(f)). However, on demand bonds areoften used in PFI/PPP projects in the UK.Such bonds are usually of a conditional

nature in that they follow an on demandformat but are subject to the condition thatany demand has to be accompanied by anadjudication award. In other words, thebondsman would have to pay where liabilityis established following adjudicationproceedings. On demand bonds are also


used in certain international projects; again,these may be of a conditional nature,usually by reference to a statement orcertificate from the engineer or contractadministrator that the contractor is indefault.

+ A secondary obligation is (again in thecontext of a bond or guarantee to anemployer) one where its enforceability isdependent on a breach by the contractor ofthe underlying building contract in favour ofthe employer. This is in the nature of asuretyship, or guarantee, obligation. If theemployer cannot establish a breach by thecontractor, then the bondsman has noliability to pay. It is this principle thatunderpins the default, conditional orperformance bonds, which are thecommonly used forms of bond in UKconstruction projects.

(c) Bonds and guarantees provide a form offinancial recourse in the event of risksoccurring. In construction projects, bonds andguarantees are typically used as security forperformance of the contractor but bonds andguarantees are increasingly provided as analternative to retention monies and also assecurity for the employer’s performance (i.e.payment). Where used as security for thecontractor’s performance, bonds are oftentreated as an alternative to a parent companyguarantee, when in fact they are very likely tohave different legal effects and provide differentremedies.

(d) As a general point, the terms of any legaldocument (such as a bond or guarantee) mustbe examined very carefully in order to ascertainits effect. In particular, in the event of a claim,detailed consideration ought to be given to thecircumstances in which any claim can be madeand the precise requirements of any notice tobe served, such as the form of the notice, theinformation to be provided within it,accompanying documents, the time for service,the correct address for service and so on.

1.4.3 Parent company guarantees

(a) A parent company guarantee is a contractbetween a parent company and a third partybeneficiary by which the parent (as guarantor)

guarantees the performance of one of thesubsidiaries. A ’parent company’ may be amisnomer; the company giving the guaranteemay be the ultimate holding company oranother company within the group ofcompanies of which the subsidiary forms apart.

(b) In the context of a typical project, this willmost likely mean a parent company of thecontractor guaranteeing to the employer theperformance of the contractor under thebuilding contract. A parent company guaranteeis often expressed (in its simplest form) as ‘A(the parent company) promises to B (theemployer) that C (the subsidiary company) willperform their contract with B’ and this is in thenature of a secondary obligation. However, itcould also mean a parent companyguaranteeing the payment obligations of anemployer, as the subsidiary company, to acontractor under a building contract. Asmentioned above, each document must bereviewed carefully to examine its correct legaleffect. A guarantee, including a parentcompany guarantee, may seek to create aprimary obligation, so that the guarantor isequally liable with the contractor and, therefore,the beneficiary of the guarantee may look toeither for performance of the primaryobligation.

1.4.4 Bonds

(a) In general terms, bonds are undertakingsgiven by one party – a bondsman – to anotherto pay money if a third party defaults.

(b) Bonds are regularly procured by contractorsin favour of employers, as security for lossescaused to employers by a contractor default(the intention being to include insolvency).However, they may be procured by contractorsin favour of employers in other instances, suchas to cover advance payments, retentionmonies and tender costs.

(c) A bond will normally be required by anemployer as a condition of entering into abuilding contract with the contractor. In the UKmarket, a commonly used form of bond is aperformance bond. This is generally a defaultbond where the bondsman’s liability is


secondary to that of the contractor, unless anduntil the contractor defaults. Such a bond oftenprovides that before the bondsman is liable,the employer (as beneficiary) must demonstratethat the contractor has failed to comply withthe relevant obligations under the buildingcontract and that the employer has sufferedloss as a result.

Insolvency itself is not a default and, if theemployment of the contractor is determined asa result of insolvency (as most buildingcontracts provide), the contractor’s failure tocomplete the works is unlikely to constitute adefault and the insolvency itself is not a breachof contract. As most forms of building contractprovide for termination of the employment ofthe contractor in the event of insolvency,without making insolvency itself a breach,consideration should be given to insolvencybeing addressed expressly within the terms ofthe bond, so that the employer should beentitled to make a claim under the bond insuch an event.

(d) A bond would normally have a financial limiton the bondsman’s liability (typically up to tenper cent of the original contract sum) and atime limit within which a claim under it couldbe made (e.g. before practical completion orcompletion of making good of defects).

(e) On international construction projects,employers often require security forperformance in the form of a primary obligationfrom the contractor’s bank. This may be in theform of an on demand bond where a bank (asbondsman) is liable to pay on receipt of, forexample, a simple statement (usually from thearchitect/engineer) that the contractor is indefault of the underlying construction contract.These bonds are ‘conditional on demandbonds’; while they impose conditions, theyplace little extra burden on the employer andshould not take away from the fact that,essentially, they are on demand bonds. Asmentioned previously, these bonds arerelatively uncommon in the UK but can be seenin use in some UK PFI/PPP projects where‘adjudication bonds’ are provided, i.e. bondswhich are payable on demand but on conditionof receipt by the bondsman of an adjudicationaward.

(f) On demand bonds tend not to be popular inthe UK construction industry. Once the demandhas been made and paid by the bondsman, thecontractor (or whoever has procured the bond)then has to recover the payment if it is able toestablish that the payment should not havebeen made or too much was paid. If theemployer, as beneficiary, had become insolventin the meantime, that would be the contractor’srisk. There are, however, certain instanceswhere there is a clear monetary risk and wherean on demand bond may be appropriate, suchas an advance payment, retention or tenderbond. In essence, these are:

+ advance payment bond: a bond usedwhen the employer makes an advancepayment to cover the contractor’s costs fora particular part of the project

+ retention bond: may be required whenthere is an early release of retention moniesby the employer; and

+ tender (or bid) bond: would entitle theemployer to payment if they have incurredsubstantial costs in a tender process andthe contractor withdraws their tender.

1.4.5 Collateral warranties

(a) As explained at paragraphs 1.1.3 and 1.1.4,a collateral warranty is a contract under whicha professional consultant, contractor or sub-contractor generally warrants to an interestedthird party that they have complied with theirprofessional appointment, building contract orsub-contract. Essentially, it creates acontractual link between the consultant/contractor/sub-contractor and the interestedthird party where one does not already exist.Without such a collateral warranty, aninterested third party will have no effectivecontractual rights against the consultant,contractor or sub-contractor responsible for adefect in the project, or a funder would not beable to exercise a right of step-in, if required.The interested third party would also beunlikely to be able to claim their lossessuccessfully under the tort of negligence.

(b) The forms of collateral warranty are usuallyannexed to the relevant contract (i.e. theappointment, building contract or sub-contract,as appropriate).


(c) There are likely to be commercial pressureson consultants, contractors and sub-contractors to agree to provide collateralwarranties in favour of interested third parties.In other words, if a consultant, contractor orsub-contractor does not agree to givewarranties and/or third party rights, that partymay not be engaged by the employer (orcontractor) for the purposes of the project. Inpractice, in many development projectsinvolving interested third parties, it would beusual for consultants, contractors and sub-contractors with major design responsibilities toagree to provide collateral warranties (or thirdparty rights), subject to agreement of themanner in which they will be provided and theirterms, taking into account the conditions oftheir professional indemnity insurance policies.

1.4.6 Third party rights(a) As discussed in paragraph 1.1.5, third partyrights are similar to collateral warranties in thatthey aim to provide an interested third partywith the same type of construction security.Third party rights allow an interested third partyto enforce the terms of a professionalappointment, building contract or sub-contractthat, otherwise, such a third party could notenforce against the professional consultant,contractor or sub-contractor. The difference isthat, whereas a warranty achieves this througha contract which is executed by the relevantparties, third party rights are granted by meansof a statute (the TPR Act) to allow such aninterested third party to have the benefit of thecontractual provisions normally contained in acollateral warranty, without needing aseparately executed contract. The interestedthird party can, therefore, rely on suchprovisions rather than have to finalise, print,sign and distribute an additional contract. Thirdparty rights are becoming increasingly moreacceptable to most interested third parties (andtheir provision is generally recognised withinindustry standard contracts as well as bespokecontracts). However, some interested thirdparties still prefer to have a written, signed anddated agreement in the form of a collateralwarranty.

(b) Third party rights are usually specifically setout in the relevant contract (i.e. appointment,

building contract or sub-contract, asappropriate). They will normally be given to aninterested third party by means of a noticeissued by the employer to the consultant,contractor or sub-contractor.

(c) In practice, parties may exclude theoperation of the TPR Act in contracts. If thirdparty rights are to be given to interested thirdparties, they must be expressly included in therelevant underlying contract as third partyrights available for the benefit of suchinterested third parties.

1.4.7 Direct agreements

(a) On more complex projects, particularly PFI/PPP projects and other major projects withinthe public sector, contractors and significantsub-contractors may be required to enter intodirect agreements with funders.

(b) The purpose of direct agreements is to givethe funder the opportunity, if the contractor orsub-contractors have a right to terminate theirworks, to step in, either directly or through anominee or representative, to remedy thetermination event or to substitute a new projectcompany or contractor. Such an agreementcreates an opportunity for the funder tocomplete the construction works and tominimise disruption to the income stream.

1.4.8 Payment security methods

(a) Payment security (i.e. securing theperformance of payment obligations under acontract) may take a number of formsincluding:

+ Escrow accounts: an account may beopened by an employer into which moniesare deposited and can be released to thecontractor under certain circumstances(e.g. on the issue of payment certificatesunder the building contract).

+ Project bank accounts: a bank accountopened usually in the names of the projectparties into which the employer must makepayments in accordance with the buildingcontract. The funds are usually held in trustand released directly to the relevantmembers of the supply chain in accordancewith their contractual entitlements.


(b) In each case, the intention is to leave theemployer as nearly as possible in the sameposition as if they were simply making paymentunder the building or other project contract.However, both the escrow account and theproject bank account are aimed at providingpayment security to the supply chain againstunjustified non-payment by, or the insolvencyof, the employer and/or the main contractor.

(c) Other methods of payment security includea direct funder guarantee, an advance paymentbond, irrevocable and unconditional letters ofcredit, or a parent company guarantee from theemployer’s ‘parent’.


2 Practical application (Level 2 – Doing)

2.1 Introduction

This section looks in more detail at the natureand purpose of certain construction securityand performance documents, including theparties that enter into them, an explanation ofwhat these documents are intended to do anda review of general provisions.

2.2 Parent companyguarantees

2.2.1 Parties

The parties are usually the employer, thecontractor and a guarantor. While the mostcommon position is the contractor procuring aparent company guarantee in favour of theemployer, to provide protection in the event ofa contractor default, in certain instances acontractor may require an employer to procurea guarantee of the employer’s paymentobligations. Ideally, the guarantor should be theultimate parent company in the group but doesnot necessarily need to be where anintermediate company is of sufficient financialstanding to be able to provide the guarantee.This guidance note focuses on the more usualposition of a parent company guarantee beinggiven on behalf of a contractor by their parentto an employer.

2.2.2 Purpose

In essence, if the contractor fails to performtheir obligations under the building contract orbecomes insolvent, the guarantor will perform,or be responsible for, the contractor’sobligations instead. If the guarantor is theparent company of the contractor, they arerequired to see to it that the contractorperforms and has sufficient funds to perform

(although, if a subsidiary is insolvent, it may bethe case that the parent is also in financialdifficulties).

2.2.3 General provisions(a) The law relating to guarantees is complexand made more difficult by there being manydifferent forms of guarantee. Specialist advicewill usually be required. General legal principlesrelating to guarantees are briefly discussed atparagraph 1.4.2.

(b) The guarantee is commonly prepared by oron behalf of the employer although manycontractors will offer their own forms or, morelikely, amendments to the employer’s form.

(c) A key provision will be one stating that theguarantor will perform the contractor’sobligations in the event that the contractorbecomes insolvent or fails to perform theircontractual obligations or will be responsiblefor losses caused to the employer by defaultsof the contractor. There may be conditions to,or limitations on, such guarantor’s liability, e.g.that the guarantor’s liability only arises if andwhen the contractor fails to perform theguaranteed obligations and then only to thesame extent as the contractor. This wordingsuggests that the guarantee is of a secondaryobligation nature but the wording of anyguarantee would always have to be carefullyreviewed. Many parent company guaranteescreate a primary obligation, so that theguarantor may be equally liable with thecontractor.

(d) The guarantee will usually state that theguarantor will not be released from theirobligations if there is an alteration to the termsof the building contract or any dispensationallowed to the contractor.

(e) There may also be a clause allowing theemployer to assign the benefit of the guarantee


to another party, e.g. to a funder or a partytaking over the employer’s interest in theproject.

(f) The guarantee may also include:

+ a ‘no greater liability’ provision, whichallows the parent company to uselimitations or exclusions of liability whichthe subsidiary company may have agreedwith the employer under their buildingcontract in any claim brought under theparent company guarantee

+ an expiry date following which the parentcompany guarantee will cease to beeffective (save, as a general rule, for claimsmade before that expiry date); and

+ a dispute resolution procedure, setting outthe rules and method of resolving anydisputes which may arise.

Figure 7 illustrates a parent company guaranteearrangement where the obligations of acontractor are guaranteed by their parent infavour of an employer.

2.3 Bonds

2.3.1 Parties

The parties are usually the employer, thecontractor and a bondsman, which is often thecontractor’s bank or an insurance company.The bondsman will generally require anindemnity or other security from the contractorbefore giving the bond.

2.3.2 Purpose

In general terms, bonds provide security forperformance by the contractor and cover thecosts of the employer (up to a financial limit) inthe event of a contractor default, such as theadditional costs associated with appointing asubstitute contractor to complete the works.This guidance note focuses on bonds procuredin favour of the employer by a contractor (butsometimes contractors require employers to bebonded to secure the employer’s paymentobligations). The bondsman undertakes to payto the employer a sum of money if thecontractor fails to perform their obligationsunder the building contract. The employer oftensees the bond as part of their constructionsecurity package designed to minimise orreduce the impact of contractor insolvency.Bonds differ from parent company guaranteesin that they provide financial compensation inthe event that a contractor fails to perform theirobligations, whereas a parent companyguarantee is intended to guarantee that theobligations are performed, which may result infinancial compensation or, in certain instances,the parent company finishing the works if thecontractor is unable to do so.

2.3.3 Types of bond

(a) There are a wide range of bonds available;some are drafted specifically for the project butstandard forms are also available (such as themodel form of guarantee bond published bythe Association of British Insurers (ABI))although they tend to be amended by theparties. The negotiations dealing with bondsare often left until late in the procurementprocess. The terms of any bond need to bereviewed very carefully (and appropriate advicetaken as required).

(b) The general legal principles relating tobonds are briefly discussed at paragraph 1.4.2,including the differences in terminology. Asmentioned, there are a variety of types of bond,including the following:

+ Performance bonds: the most commonlyused forms of performance bonds in a UKconstruction project are default bondsissued by a bondsman on behalf of a


contractor, i.e. they are conditional on theproper performance of the building contractby the contractor. If the contractor does notperform their obligations in accordance withthe building contract, the bondsman agreesto pay the employer their losses up to astated maximum sum, often a percentageof the initial contract sum. Figure 8illustrates the operation of a performancebond.

+ Advance payment bonds: used when theemployer makes an advance payment(sometimes called a ‘down payment’) tocover the contractor’s setting up costs or

costs for a particular part of the project.There may be good commercial reasons forthe employer making such advances,primarily a saving on the contract price.Unless the employer retains some controlover the advance, it may be diverted tosome other use within the contractor’sorganisation. The bond, therefore, protectsthe employer and can be called if themonies advanced are not used for theproject. They are generally on demandbonds.

Figure 9 illustrates the operation of an advancepayment bond.


+ Retention bonds: may be required wherethere is early release of retention monies orpayment under a building contract grosswithout deduction. These are generally ondemand bonds which require thebondsman to pay a sum equivalent to theretention monies, which would otherwisehave been retained from payments dueunder the building contract.

Figure 10 illustrates a retention bond structure.

+ Tender (or bid) bonds: in general, entitlethe employer to payment if, after they have

spent a great deal of time and expensenegotiating with a contractor, the contractorthen withdraws their tender and refuses tocontract with the employer, possiblydelaying the project and forcing a re-tender.The amount stated in the bond may be aspecific sum or a percentage of the tenderprice subject to a maximum sum. Suchbonds are generally on demand bonds butare relatively unusual in domestic UKconstruction projects.

Figure 11 illustrates the structure of a tenderbond.


2.3.4 General provisions

These will depend on the type of bond beingprovided. However, bonds will usually containkey provisions setting out the amount of thebond, the circumstances in which a call or ademand under the bond can be made, theprocedures which need to be followed whenmaking a call or demand and an expiry date.

2.4 Collateral warranties

2.4.1 Parties

Collateral warranties are normally given bycontractors, certain sub-contractors and theprofessional consultants (often called‘warrantors’) in favour of one or more interestedthird parties. The employer is also often a partyto the warranty document in order to consentto the arrangement. In some instances (usuallyin a design and build method of procurement),warranties are also given to the employer bythe professional consultants employed by thecontractor (the consultants are often originallyappointed by the employer and theirappointments novated (or transferred) to thecontractor on or before the commencement ofconstruction, in which event they will normallyprovide a collateral warranty to the employer).

2.4.2 Purpose

A collateral warranty is a contract between athird party with an interest in the project underconstruction, or the completed project, and aperson who is or was involved in the design,management and/or construction of thatproject. When taking an interest in a new,recently built, or recently refurbished property,an interested third party will usually want tominimise the risk that they will have to pay forthe remedy of any problems or defects in thatproperty or project – they want constructionsecurity. A funder providing developmentfinance to an employer will also wantconstruction security to help protect their loan.In other words, if something goes wrong on theproject, the interested third parties will want torecover any losses from those responsible –collateral warranties should enable them to doso. A funder may also want to be able to step

in and build out the project if the employerdefaults in some way (e.g. becomes insolvent)before the project is completed. The collateralwarranty enables the funder to do this by usingstep-in rights, although the funder is usuallyobliged to make good any payments thenoutstanding to the warrantor before it canexercise those step-in rights.

A collateral warranty, therefore, creates a dutyand set of rights in contract in favour of theinterested third party, which would nototherwise have existed because of the doctrineof privity of contract, which is explained atparagraph 1.1.3. Without such a contractuallink, a third party is very unlikely to have anysuccessful right of legal recourse against theparty which was responsible for a defect in thedesign and/or construction of the project(whether in contract or tort). This is explained ingreater detail at paragraphs 1.1.3 and 1.1.4.

2.4.3 The beneficiaries of warranties

Warranties may be given by contractors, sub-contractors and professional consultants infavour of:

+ the employer (if they have not directlyemployed the warrantor)

+ funders

+ any purchaser or tenant of the wholeand/or any part of a newly built propertyonce it is completed; and/or

+ other interested parties, such as freeholdersand management companies.


(a) Warranties usually contain an undertakingfrom the warrantor in favour of the interestedthird party that the warrantor has performedand/or is performing their works and/orservices to the standard required under theirprimary underlying contract with the employer.For example, a warranty from a consultantmight state that the consultant ‘warrants to [theinterested third party] that it has performed andwill continue to perform the services exercisingthe reasonable skill, care and diligence to beexpected of a competent consultant of therelevant discipline who is experienced inproviding similar services in connection with


projects of a similar size, scope and complexityto the Project and otherwise in accordancewith the terms of the Appointment’.

(b) If the warrantor has any significant designliability, there will usually be an obligation in thewarranty that the warrantor should maintainprofessional indemnity insurance up to anagreed level and for a specified period. Thewarrantor would normally also be required toprovide evidence that such insurance cover isin place.

(c) There may be an obligation on the warrantornot to specify or incorporate (or allow to beincorporated) in the works certain prohibitedmaterials. Sometimes these materials arespecifically listed in the warranties, or thewarranty could simply refer to an agreedmaterials standard or standards.

(d) There may be provisions limiting thewarrantor’s liability. For example, there may bea clause limiting the liability of the warrantor toa certain amount (often linked to the level oftheir professional indemnity insurance cover).There could also be clauses restricting thelosses which a third party beneficiary might beable to recover from a warrantor in the event of

a claim, e.g. to the reasonable cost of repair,renewal and/or reinstatement of the propertycaused by the warrantor’s breach (so that,among other things, loss of rents cannot berecovered).

(e) Some warranties may also contain a ‘netcontribution’ clause which states that thewarrantor’s liability should be limited to suchsum as is ‘just and equitable’ (in other words,fair), given its responsibility for the loss ordamage suffered and certain statedassumptions.

Figure 12 illustrates how a net contributionclause can work.

(f) A warranty typically includes a ‘no greaterliability’ and/or ‘equivalent rights of defence’clause. A no greater liability clause providesthat the warrantor cannot have a greaterliability under the collateral warranty to theinterested third party than they would have tothe employer under the appointment or buildingcontract. An ‘equivalent rights of defence’clause provides that the warrantor may use anydefence that they may have under theprofessional appointment or building contractto defend a claim from the interested thirdparty beneficiary under the collateral warranty.


These types of provisions might allow, amongother things, a right of set-off, i.e. the right forthe warrantor to set-off the amount of anyclaim which they may have against theiremployer (such as for non-payment of fees orfor unpaid works) against any claim made bythe interested third party beneficiary under awarranty. Such a right of set-off by thewarrantor may be expressly excluded by theterms of the collateral warranty, i.e. thewarrantor would not in the circumstance beable to put forward a right of set-off in anyclaim by the interested third party under thewarranty.

These types of clauses are the reason why aninterested third party beneficiary would verylikely want to review the terms of theappointment and/or building contract whennegotiating and agreeing the terms of acollateral warranty, because the benefits givenby a collateral warranty (or by third party rights)may be limited by the terms of the principalunderlying contract itself. This also applies tosub-contracts where sub-contractor warrantiesare being provided. Copies of sub-contractswill (most likely) also need to be supplied toeach interested third party beneficiary ofcollateral warranties or third party rights, withcommercial information edited out.

(g) When the warrantor is responsible fordesign, the warrantor will usually retaincopyright in their design, but the beneficiarywould be granted a copyright licence to useand reproduce design documents prepared bythe warrantor for certain purposes. Sometimes,there is not only a provision in a warrantygranting a licence in respect of copyright, butalso an indemnity provision indemnifying theinterested third party in respect of any claim itmay suffer as a result of the warrantorinfringing or being held to infringe anycopyright. There may also be a provisionstating that the warrantor shall not be liableunder the collateral warranty for any misuse bythe beneficiary of design documents andmaterials (i.e. any use other than that for whichsuch documents and materials were preparedby the warrantor).

(h) The beneficiary of a warranty may want theright to assign the benefit of the warranty to

another party who takes that beneficiary’sinterest in the project (and further onwardassignments). The warrantor will often seek tolimit this right, e.g. by limiting the number oftimes the benefit of the warranty can beassigned.

(i) Parties providing warranties should normallyseek to review their terms with their legal orinsurance advisers before they are agreed,since they are long-term obligations. The formof warranty is often agreed in tandem with theappointment or building contract so that, ineffect, the warranty represents a documentnegotiated and agreed between the parties atthe outset, often long before the warranty hasto be given.

Figures 6a and 6b illustrate projects wherecollateral warranties are being given andreceived by relevant parties.

2.5 Third party rights

2.5.1 Parties

A relevant party (contractor, sub-contractor orconsultant) agrees in the terms of the relevantunderlying contract (i.e. the building contract,sub-contract or appointment) to give third partyrights to an interested third party.

2.5.2 Purpose

Third party rights allow an interested third partyto enforce a specific term (or set of terms) inthe underlying contract, which that third partywould otherwise not have been able to dobecause they are not a party to that contract.The purpose of third party rights in most UKconstruction projects is to establish acontractual relationship in the same manner asa collateral warranty. This is achieved bymeans of statute – the TPR Act – which allowsa third party beneficiary to have the benefit ofcontractual provisions (such as those normallycontained in a collateral warranty) without theneed for a separate, signed and executed,contract. The background and effect of theTPR Act is described in greater detail atparagraph 1.1.5.


2.5.3 The beneficiaries of third partyrights

Third party rights may be given by contractors,sub-contractors and consultants in favour of:

+ the employer (if they have not directlyemployed the party giving the third partyrights)

+ funders

+ any purchaser or tenant of the wholeand/or any part of a newly built propertyonce it is completed; and/or

+ other interested third parties, such asfreeholders and management companies.


Third party rights are a set of rights granted byone party in favour of another (third) party whois not a party to the contract, to enforce certainterms of a contract. Third party rightscommonly appear either within a standaloneschedule to the building contract, sub-contractor appointment setting out the terms that aninterested third party may enforce, or as aschedule listing the clauses that an interestedthird party may enforce. There should be aprovision within the relevant underlying contractsetting out how such third party rights areeffectively granted in favour of an interestedthird party. Usually, this is by means of a noticeserved by the employer on the party providingthe benefit of the third party rights which willidentify the interested third party in whosefavour such third party rights are being given.Third party rights are similar or equivalent tothe general provisions discussed at paragraph2.4.4 in the context of collateral warranties.

Parties giving third party rights will be in thesame position as parties providing collateralwarranties and will normally wish to review theterms of such third party rights with their legalor insurance advisers before they are agreed. Aparty receiving the benefit of third party rightswould, as in the case of collateral warranties,very likely want to review the relevant contractunder which such rights are purported to begiven. This would not only be because thebenefits received under third party rights maybe subject to the terms of such contract but

also to check the manner in which such thirdparty rights are being conferred on them.

Figures 6a and 6b illustrate projects where thirdparty rights are being given and received byrelevant parties.

2.6 Direct agreements

2.6.1 Parties

The parties are the funder and the contractorand, sometimes, the funder and key sub-contractors. The employer is also usually aparty to the agreement to show their consentto the arrangements within it.

2.6.2 Purpose

Direct agreements generally allow the funder tostep into the shoes of the employer in theevent that the employer becomes insolvent ordefaults in relation to the loan obligations theyowe to the funder under the facility agreement.Funders will usually require direct agreementsin relation to the building contract, importantsub-contracts and other key agreements usedin larger projects, such as operating/facilitiesmanagement agreements (which operate oncethe project has been constructed).


A key provision is a step-in clause which allowsthe funder to take control of the relevantcontract following an event of default by theemployer. The funder will usually have thepower to arrange for a new body/projectcompany to take over the administration of theproject from the employer.

The direct agreement will usually require theother parties to the relevant contract (such asthe contractor in the case of the buildingcontract) to forego or suspend any rights theymight have to terminate the contract while thefunder finds a substitute project company. Theclause will usually require the funder to find abody with the same level of experience andfinancial resources as the original employer.

Figure 13 illustrates the structure where directagreements are entered into relating to aproperty development transaction.


2.7 Payment security methods

2.7.1 Escrow account

A typical building contract requires regularpayments by the employer to the contractor aswork progresses. An escrow account may beused as a safeguard for all payments or it maybe put in place as a safeguard to be calledupon only if the employer fails to make one ofthe payments owing under the buildingcontract.


An escrow account is usually documented bythe following:

+ a contract that formalises the escrowarrangements

+ a letter instructing the bank or other escrowagent how to operate the account; and/or

+ an amendment to the building contract toadjust the payment provisions to takeaccount of the escrow arrangements.

The contracts should clearly set out what sumsare to be paid into the escrow account and

when and how the funds are to be distributedfrom the account. There may be provisionsunder which the monies in an escrow accountare held on trust for the contractor in order toring-fence such monies in the event ofemployer insolvency.

2.7.3 Project bank account

A project bank account is intended to speedup payment in a construction project, reducingthe risk of cash flow problems in the supplychain. This is because, depending on the termsof the relevant agreements, a payment from theemployer to the contractor does not have toflow down from the contractor to their sub-contractors – they are all paid at theappropriate time through the project bankaccount. In essence, the employer andgenerally the main contractor jointly open theproject bank account and money is paid into itby the employer in accordance with thecontractor’s contractual entitlements. Themonies in the account are usually held in trustby the employer and the contractor for thebenefit of the contractor and their supply chain.Therefore, the supply chain should have access


to the monies if the contractor becomesinsolvent. Project bank accounts are more likelyto be seen in public sector projects but areincreasingly being used on major projects.


There will normally be a provision in thebuilding contract setting out the project bankaccount provisions. There may then be aseparate agreement dealing with the projectbank account itself. The key provision is anundertaking from the employer to pay moniesdue under the building contract into the projectbank account as and when they become due.The contractor will identify sub-contractors thatwill be paid directly from the account. Theremay be provisions stating that the monies paidinto the account are kept separate and distinctand clearly identifiable, and that they will beheld on trust for the contractor and otherrelevant parties until they are ultimately paid.As with the escrow account provisions referredto previously, the intention is to create a trust,ring-fencing the funds in the account for thebenefit of the parties to be paid in connectionwith the project.


3 Practical considerations (Level 3 –Doing/Advising)

3.1 IntroductionThis section looks at practical considerationswhich a chartered surveyor should take intoaccount when reviewing construction securityand performance documents in a constructionproject. It is important to note, however, thatthis guidance note is a brief introduction andshould not be relied on as a substitute forappropriate professional advice.

3.2 Parent companyguarantees – items forconsideration3.2.1 The form of parent company guarantee isusually prepared by the employer, althoughmajor contractors often have their own forms ofguarantee that they prefer to use to guaranteethe performance of a subsidiary on a particularproject. The law relating to guarantees iscomplex; specialist advice should be sought,where appropriate. Background information onthe general principles of law in this area isprovided at paragraph 1.4.2.

3.2.2 The parties should carefully consider thereasons for a parent company guarantee and (ifappropriate) any additional or alternativesecurity that the contractor or the employermay be able to provide, e.g. in the case of abuilding contract, if a performance bond isbeing provided, is it necessary to provide aparent company guarantee as well? This willdepend on the particular project: often, incomplex projects, both will be required.Performance bonds and parent companyguarantees provide different remedies, typesand levels of protection to the employer forcontractor default. Bonds (among other things)provide access to a pot of money to cover thecost of appointing a substitute contractor if the

original contractor becomes insolvent; parentcompany guarantees attempt to ensure that theparent will ‘see to it’ that their subsidiaryperforms in a potential default situation. Clearly,if the contractor does not have a parentcompany (or other appropriate company withinthe group) a parent company guarantee cannotbe given and other security (such as a bond)may be sought.

3.2.3 Consideration should be given to whichbody is providing the parent companyguarantee. Is it the ultimate holding company inthe group or an intermediate company? Whereexactly does the company giving the guaranteesit within the company’s overall groupstructure? Financial checks on the bodyproviding the guarantee will be required. Theaim should be to obtain a guarantee from acompany within the group which ownssignificant assets. For example, in the case ofan employer, it is common in manydevelopment projects for developers to set upspecial purpose vehicles (SPVs) which havevery few assets. The important point is toundertake financial checks; such checks mayshow that the parent company or even theultimate holding company have fewer assetsthan the contracting party themselves, whichwould therefore mean that any parent companyguarantee given by these companies will be oflittle additional value. However, it may bedifficult, in practice, to ascertain where controland ownership of the group assets really lie. Aparent company guarantee will, of course, beof little or no benefit if the parent is ultimatelyequally unable to perform the contract (e.g. ifthere is a group insolvency). This is likely to bea factor to consider in choosing whether tohave a performance bond in place of, or aswell as, a parent company guarantee.

3.2.4 Where is the company giving theguarantee resident? Is it a company registered


in the UK or an overseas company? It wouldbe necessary to consider what assets anyoverseas company has (and it may be difficultto carry out financial checks or, at least,financial checks which are then current) andhow any judgment could be obtained orenforced against that company in the event ofa claim under the guarantee.

3.2.5 In what circumstances will the guarantorbe liable under the parent company guarantee?For example, does the guarantee cover thecontractor’s insolvency? There is legal authorityto suggest that insolvency itself is notautomatically a breach of a building contract(see paragraph 1.4.4(c) for further details). Isinsolvency defined in the guarantee and is it asatisfactory up-to-date definition?

3.2.6 Is the parent company guarantee a ‘seeto it’ guarantee or an indemnity? If theguarantor’s guarantee of the contractor is asecondary obligation, the guarantor’s liabilityarises if and when the contractor fails toperform the guaranteed obligations. Aguarantee may, however, include a primaryobligation, such as an indemnity, where theguarantor’s obligation is independent of thecontractor’s obligations to the employer underthe building contract and may extend beyondthe scope of such obligations.

3.2.7 Does the parent company guaranteeinclude a provision which states that theguarantor is not released from its liabilitiesunder the guarantee if an amendment is madeto the building contract or if some other formof dispensation is given under it (such as anextension of time to the date for completion ofthe works)? An amendment to, or dispensationunder, the building contract (or underlyingguaranteed obligations) without the guarantor’sconsent may release the guarantor from theguarantee.

3.2.8 What is the duration of the liability of theguarantor under the parent companyguarantee? Is the guarantee effective as longas the obligations and liabilities of thecontractor remain alive under the buildingcontract, or does the liability of the guarantorcease at a particular time, such as oncompletion of making good defects?

3.2.9 Is there any limitation of liability provisionwithin the parent company guarantee? Fromthe employer’s perspective, the guarantorshould be liable at least to the same extent asthe contractor. Subject to this, it might bereasonable to expect the guarantor to want toinclude a provision within the guarantee thatthe guarantor should not be more liable to theemployer than the contractor is under thebuilding contract.

3.2.10 A funder will typically require the benefitof a guarantee to be charged to them by wayof security for their loan (along with the benefitof any other security documents). An employerwill, therefore, want to be able to assign andcharge the benefit of the guarantee as well asthe building contract. Most parent companyguarantees will, therefore, include anappropriate assignment provision.

3.2.11 How is the parent company guarantee tobe executed and by whom? A parent companyguarantee will most likely be executed as a deedrather than as a simple agreement (i.e. simplysigned by the parties). A document can beexecuted as a deed by a company by using theircommon seal, which must be affixed and authen-ticated in accordance with that company’s Arti-cles of Association. A company could alsoexecute a document as a deed by two directorsexecuting the document, or one director and acompany secretary, or even by one director in thepresence of a witness who then attests that direc-tor’s signature. If the parent company is a foreignentity, there may be different rules regardingexecution – it may be necessary to ask a law firmin the company’s home country to produce alegal opinion stating that the parent company isproperly formed, has the power to enter into theguarantee and has executed it in compliance withthe laws of that country.

3.3 Bonds – items forconsideration3.3.1 Bonds are generally issued by specialistsurety companies, insurance companies orbanks. An employer may have a particularbespoke form of bond that the employer willwant a bondsman to sign but often the


bondsman will want to introduce amendmentsor their own form of bond. Certain standardform bonds are on the market (such as themodel form of guarantee bond published bythe ABI). Careful consideration should be givento the terms of whatever form of bond isoffered and, if necessary, appropriate advicesought (such as legal and financial advice).

3.3.2 As mentioned, in the context of a parentcompany guarantee in paragraph 3.2.2,consideration should be given as to whetherboth a bond and parent company guaranteeare required. An employer will wish to havesufficient security in place in the event of acontractor default (such as insolvency). Oftenthe decision is out of the employer’s hands astheir funder may insist on both being procured.A contractor may be unwilling to offer bothand, of course, there is a price for doing so. Acontractor will normally charge a premium forthe provision of a performance bond whereas aparent company guarantee should not havecost implications for the contractor (save,perhaps, for an administration charge). It may,however, be a contingent liability in thecontractor’s books and may affect the amountof money they can borrow.

3.3.3 It is worth noting (in making a decision asto whether both are required) that bonds andguarantees are designed to protect againstdifferent risks. The bond is designed to providerelatively short term cover for a contractordefault and a parent company guarantee actsas longer term security (generally for theduration of the contractor’s liability under theunderlying guaranteed contract).

3.3.4 As with a party providing a parentcompany guarantee, it is necessary to considerthe status and financial worth of the bodyproviding the bond including, where applicable,its financial rating. Other financial checks onthe bondsman are likely to be required. Whereis the body resident? Is it a company registeredin the UK or an overseas company? It will benecessary to check the financial status of anyoverseas body (and it may be difficult to carryout current financial checks) and how anyjudgment could be obtained or enforcedagainst that company in the event of a claimunder the bond.

3.3.5 Check the form of the bond and itspurpose. A commonly used form of bond in aUK development project is a performance bond(see paragraphs 1.4.4(c) and 2.3.3(b)). Is thebondsman undertaking to pay a sum of moneyto the employer if the contractor fails toperform their obligations under the buildingcontract? Does the bond cover the contractor’sinsolvency? As mentioned in the context of abond (see paragraph 1.4.4(c)), insolvency ofitself is not, strictly speaking, a breach of abuilding contract. Therefore, it is necessary toexamine whether the terms of the bondexpressly cover this event (and to review howinsolvency in this context is defined in thebond, e.g. is it by reference to a particulardefinition in the building contract and is thatdefinition satisfactory?). Further, is the bond ofan on demand nature (see paragraph 1.4.2(b)),perhaps conditional on the presentation ofdocumentation (such as a statement from thecontract administrator that the contractor is indefault)? As mentioned, on demand bonds areless commonly seen in UK projects but theiruse may increase during periods of economicdownturn. Certain on demand bonds of aconditional nature are often used in UK PFI/PPP projects, such as adjudication bonds (seeparagraph 1.4.2(b)). Bonds are usually of an ondemand nature if they cover advancepayments, retention monies or tender costs.

3.3.6 What is the sum covered by the bond?Bonds normally have a limit on the amountavailable to be called by the employer undertheir terms. The maximum amount of coveravailable is often expressed as a percentage ofthe original contract sum, usually ten per cent.

3.3.7 When does the bond expire? Bondsnormally have an expiry date. This could be aspecified date, the date of issue of a certificateunder the building contract or some otherevent anticipated by the contract. A requestmay be made on behalf of the contractor or thebondsman for the bond to expire on the issueof a statement or certificate of practicalcompletion. An employer is likely to want thebond to remain alive during the defects liabilityperiod until the issue of a statement orcertificate of completion of making gooddefects.


3.3.8 The bond may be a reducing bond,reducing from, say, ten per cent to five per centon practical completion, with the remaining fiveper cent being extinguished on completion ofmaking good defects. To make a specificexpiry date enforceable, the bond would haveto provide that after expiry the bondsmanceases to be liable to the employer absolutely.In those circumstances, it is important from theemployer’s perspective to check that the cut-off date does not apply to claims alreadynotified by the employer to the bondsmanbefore that date.

3.3.9 As with a parent company guarantee, afunder will typically require the benefit of abond to be charged to it. Most bonds will,therefore, contain an assignment provision.

3.3.10 If a call is to be made under the bond, itwill be necessary to check the requirementsthat need to be followed, e.g. is it a conditionthat a demand has to be made within aparticular period after a relevant default hasoccurred? It will be necessary to review theformal requirements of notifying a claim orissuing a demand under any bond. Detailedconsideration needs to be given to the preciserequirements of any claim or demand to beserved, such as the form of the notice, theinformation to be provided within it,accompanying documents, the time for service,the correct address for service and so on. Anyrequirements of this nature must be strictlycomplied with otherwise the claims may berejected by the bondsman.

3.3.11 How is the bond to be executed and bywhom? Usually, the bond is to be executed byboth the bondsman and the contractor. It willnormally be executed as a deed, so checks willneed to be made to ensure that it has beenproperly executed in accordance with the lawof the place where the bondsman is resident. Ifthe bondsman is a foreign entity, there may bedifferent rules regarding execution – it may benecessary to ask a law firm in the company’shome country to produce a legal opinionstating that the bondsman is properly formed,entitled to issue bonds in the circumstancesenvisaged and has executed the bond incompliance with the laws of that country.

3.4 Collateral warranties –items for consideration

3.4.1 By a collateral warranty, partiesresponsible for the design and/or constructionof the project (contractors, sub-contractors andconsultants) promise an interested third partybeneficiary to carry out the works or services inaccordance with the underlying contract (suchas the building contract, sub-contract orconsultant appointment). The commercialproperty development market often refers tothese collateral warranties as ‘purchaser ortenant’ or ’funder’ warranties. Other specialistsectors (e.g. the public sector in PFI/PPPprojects) use different forms or variants ofcollateral warranties – ‘direct agreements’ – infavour of parties relevant to their sector. Directagreements are discussed in more detail atparagraph 3.7.

3.4.2 Does a warranty have to be given? Awarranty would not have to be given unlessthere is a binding obligation upon a party togive it. It would be rare, in most developmentprojects, for such an obligation not to beincluded within the underlying contracts, suchas the building contract, sub-contracts andappointments. This is because of therequirement of interested third parties to havesuch warranties in place (often as aprecondition to funding or their agreement topurchase or take a lease of the property). Theremay be incentives to give the warranties withinthe contract, such as the right of the employerto withhold monies until the warranty is given,or a requirement for the beneficiary to pay astated amount to the warrantor for giving thewarranty (although this is often a nominalamount). However, there is normally sufficientcommercial pressure on consultants,contractors and sub-contractors to agree toprovide collateral warranties. As employers arenormally required to procure such warranties infavour of interested third parties, they will onlywant to engage consultants and contractorswho are willing to give them.

3.4.3 The form of warranty which the warrantoris to give to interested third parties will often beannexed to the underlying contract. This couldbe a standard form published by a relevant


organisation but in most major projects thewarranty is likely to be in a bespoke formprepared by the employer. In either case, thewarrantor has the opportunity to agree the formof warranty often long before they will have togive it. In the case of building contracts, anissue can arise where the contractor has toprocure sub-contractor warranties. This isbecause it is often the case that the agreementof sub-contract terms only takes placefollowing the completion of the buildingcontract. As a result, the contractor may beagreeing to procure sub-contractor warrantiesin favour of interested third parties in a formwhich they have not yet agreed with the sub-contractors.

3.4.4 Check whether there are any limitationson the obligation to give collateral warrantieswithin the underlying contract. Is there alimitation on the types of beneficiaries to whomwarranties have to be given or a limit on thenumber that can be given? The party providinga warranty may stipulate, for example, thattheir warranty should only be given to a ‘first’tenant (the original tenant taking a first lettingwithin the building), to a tenant who is taking a‘substantial’ letting (this wording is often usedbut begs the question of what is ’substantial’?),to a limited number of tenants, or acombination of these elements.

The obligation to provide a fixed number ofwarranties (e.g. five in total) should not beconfused with the ability of a third partybeneficiary to assign the benefit of a warrantyto another party who may, for example, betaking their interest in the project. Taking thisexample further, Consultant X agrees to providea total of five warranties which are given totenants A, B, C, D and E. No more warrantiesare available to be given by Consultant X.However, each warranty may be assignable sothat, for example, Tenant A can assign thebenefit of the warranty to a substitute tenant(A1) taking A’s interest in the property.

3.4.5 A collateral warranty usually includes aclause in favour of the interested third partythat requires the warrantor to confirm that theyhave complied, and will comply, with the termsof the professional appointment or buildingcontract they have entered into with the

employer. Additionally, where the warrantor hasa design responsibility, collateral warranties willusually include an obligation to comply with theprofessional appointment or building contractand an obligation to exercise reasonable skill,care and diligence in carrying out design.Consequently, it will be necessary to establishwhat type and standard of duty of care is beingprovided under the warranty.

3.4.6 The warranty should be reviewed toestablish whether there are any limitations onthe liability of the party giving the warranty. Thewarranty may seek to include a limitation onthe ability of the interested third party to makea claim so that such party can only, in theevent of a defect, recover the cost of rectifyingand repairing damage directly caused by suchdefects (thereby excluding other losses, suchas loss of profit, rent, etc.).

3.4.7 There may be other limitations on theliability of the warrantor contained within thewarranty. The warranty may provide that anylimitations or exclusions within the underlyingcontract (such as a cap on liability) should applyequally to any claim under the warranty. Acollateral warranty usually includes a ‘no greaterliability’ and/or an ‘equivalent right of defence’clause. These are explained in detail atparagraph 2.4.4(f). As a result of such clauses, itwill be necessary to review the terms of therelevant underlying contract as much as theterms of the collateral warranty itself.

3.4.8 Most collateral warranties will include aclause limiting the period during which thebeneficiary may make a claim against thewarrantor. It will be necessary to check whatthat period is – it is often 12 years frompractical completion of the project (althoughconsultants or their advisers might suggest thatthis period should be 12 years from the datethe services have been completed, which maybe earlier). Sometimes a period of six yearsfrom practical completion (or completion of theservices) may be put forward. This needs to beconsidered in the context of the period withinwhich claims must be made as a matter of law,which is discussed further at paragraph 3.4.14.

3.4.9 Another clause seeking to limit the liabilityof a warranty is a ‘net contribution’ clause. Thisclause is normally worded to the effect that,


where two or more parties involved in theconstruction project are each jointly liable forthe same loss or damage, their liability islimited to an amount which would beapportioned to that party by a court on a ‘fairand reasonable’ or ‘just and equitable’ basis.Figure 12 illustrates this concept.

3.4.10 Copyright in the designs, drawings andother materials produced by the warrantor willnormally remain with the warrantor. As a result,there will often be a copyright licence in favourof the interested third party beneficiary within acollateral warranty. This is a clause in thewarranty granting the beneficiary a licence touse and reproduce the copyrighted materialswhich have been produced by the warrantor inrelation to the project. Are there any limitationsto the proposed copyright licence, e.g. is thelicence only available if all outstanding costsand fees of the warrantor have been paid? Isthe copyright licence irrevocable? Is it royalty-free? The purposes for which the licence maybe used will normally be set out (e.g. ‘for anypurpose related to the Development’). Thelicence might apply to the use of thedocuments (e.g. for maintenance purposes)where there is an extension of the developmentbut the rights under the licence may not extendto reproducing the designs contained in thedocuments for the purposes of building anextension to the development. There may alsobe a clause which provides that the warrantorwill not be liable to the beneficiary for any useto which the documents are put, where thatuse is for a purpose other than that for whichthe documents were prepared by the warrantor.

3.4.11 There will usually be a clause in thewarranty obliging the warrantor to maintainprofessional indemnity insurance cover (oftenfor 12 years from practical completion),provided that the warrantor has a design (ormanagement) obligation. These provisions mayvary in content and effect and should beexamined carefully. It is important to recognisethat professional indemnity insurance isrenewable annually and is issued on the basisthat it covers claims made during the period ofinsurance. What is the level of professionalindemnity insurance cover required by thewarranty? It will probably be at the level statedin the underlying contract. Is the amount

sufficient for the purposes of the project? Thisquestion is an extremely difficult one to answer;consideration has to be given to, among othermatters, what levels of losses could beincurred if the warrantor was in breach of theirunderlying contract. The clause in the warrantywill usually require evidence of professionalindemnity cover to be produced by thewarrantor, which may be, for example, abroker’s letter showing the extent of cover.

3.4.12 A collateral warranty in favour of afunder includes some important differencesfrom warranties in favour of purchasers andtenants. It is usually entered into by theemployer as well as by the warrantor (and thefunder). A key difference is the inclusion of aright of step-in. A step-in right allows a funder(or a party nominated by the funder) to takeover the employer’s role on a project. Thiswould usually be where the employer is indefault, which means they are in breach of theterms of the funding agreement, they areinsolvent and/or they have not complied withthe terms of their professional appointments orbuilding contract. It will be necessary to reviewthe funder warranty in this respect. Does thefunder have the right to step into the shoes ofthe employer, and in what circumstances?When does the funder have to make a decisionto exercise such a right? Are there anyobligations on the funder exercising step-inrights to make payments, e.g. any paymentsthen outstanding to a warrantor, before theycan exercise their step-in rights?

3.4.13 There is likely to be a provision allowingthe interested third party beneficiary to assignthe benefit of the warranty to another party. Ineffect, the other party takes on the rights thatthe original beneficiary had under the warranty.It will be necessary, therefore, to review theassignment provisions, if any, of the warranty.Is the beneficiary entitled to assign the benefitof the warranty without the consent of thewarrantor? If so, is this limited to a set numberof times? Is the consent of the warrantorrequired? If consent is not required, does thewarrantor have to be notified of anyassignment (and is such notification a pre-condition to a valid assignment)? It would beusual to see a provision which seeks to imposea limit on the number of occasions that the


warranty could be assigned by the interestedthird party beneficiary. This may be becausethe professional indemnity insurers of thecontractor and consultants require such alimitation so they have some idea of the likelyextent and duration of the warrantor’s potentialliability.

3.4.14 It will be necessary to check how thewarranty is executed and whether thatexecution is valid. Does the document statethat it is to be executed as a deed? If so,check that the document has been executedcorrectly. Is it to be signed as a simplecontract, under hand? If so, is thereconsideration on the face of the warranty, e.g.that a payment is being made by thebeneficiary to the warrantor in consideration ofthe warrantor entering into the warranty? Thismay be a nominal payment, for example £10.The basis on which the warranty is to beexecuted is important. Firstly, where thewarranty is to be signed under hand as asimple contract, the warranty must provide forconsideration. Further, as a general principle,warranties signed under hand are subject to asix year period of limitation of action (i.e. legalproceedings have to be instituted within sixyears of the breach complained of), whereaswarranties executed as a deed are subject to a12 year limitation period. Clearly, thosereceiving warranties will usually be looking for a12 year limitation period. This needs to belooked at in the context of any expressprovision within the warranty, which providesthat the interested third party beneficiary has tocommence proceedings against the warrantorwithin a set period of time (see paragraph3.4.8).

3.5 Third party rights – itemsfor consideration3.5.1 Third party rights are rights provided forunder the TPR Act which allow an interestedthird party beneficiary to enforce the terms of abuilding contract, sub-contract or consultantappointment, that otherwise the third partycould not enforce against the contractor, sub-contractor or consultant because thebeneficiary is not a party to that contract. Such

rights can, therefore, create a contractualrelationship in the same manner as collateralwarranties. This is explained in greater detail atparagraph 1.1.5.

3.5.2 In general, third party rights will beprovided to the interested third partybeneficiaries to whom collateral warrantieswould otherwise be provided. Therefore, thecomments made in paragraph 3.4, in relation towarranties, generally apply to any third partyrights being offered to an interested third party.

3.5.3 Parties drawing up relevant contracts willwant to consider whether to provide forcollateral warranties alone or third party rightsalone, or to retain the flexibility of being able toprocure both collateral warranties and thirdparty rights in favour of interested third partybeneficiaries (albeit that such beneficiaries canonly receive one or other of them, not both).

3.5.4 Third party rights are now morecommonplace in development projects and,indeed, are specifically provided for in certainstandard forms of contract, such as thosepublished by the JCT. Using third party rightsmay help reduce paperwork and save time onconstruction projects, because separatecollateral warranty documents do not need tobe negotiated, executed and returned. Delaysand additional expenditure should, therefore,be avoided. However, certain interested thirdparty beneficiaries may still be reluctant toaccept third party rights instead of receivinghard copy, signed and dated, collateralwarranties.

3.5.5 The requirement to provide third partyrights, and the terms of such rights, will be setout in the underlying contracts (i.e. the buildingcontract, sub-contracts and appointments). It isessential that, if required, a third party is giveneffective third party rights, i.e. rights that areenforceable and on which the third party canrely. If a collateral warranty is properlycompleted, an interested third party whowishes to claim under it will look at the termsof the collateral warranty. If an interested thirdparty is relying on third party rights, thecontractor, sub-contractor or consultant willseek to establish whether that third partyactually has the right to enforce the relevantprovisions of the underlying contract.


3.5.6 It will be necessary, therefore, to examinehow such third party rights are given in favourof interested third party beneficiaries. If thirdparty rights are provided for, there must be amechanism within the relevant underlyingcontract for such third party rights to be givento a beneficiary. For example, the third partymust have been sufficiently identified within therelevant underlying contract.

3.5.7 Most underlying contracts will identify thethird party rights to be given to a beneficiaryeither by including them within a standaloneschedule or by a schedule identifying theclauses that a third party may enforce. Themeans by which such rights become effectivepursuant to the underlying contract also needto be reviewed. This is often by means of anotice (in a prescribed form) being sent by theemployer to the relevant party giving the thirdparty rights (i.e. the contractor, sub-contractoror consultant). The operative clause may referto more than one schedule of rights fordifferent classes of third party, e.g. there islikely to be one schedule for purchasers andtenants and one schedule for funders (just asthere are likely to be separate collateralwarranties in favour of purchasers and tenantson the one hand, and funders, on the other).

3.5.8 The relevant statute (the TPR Act) whichenables third party rights to be given alsoprevents the parties to the underlying contractrescinding or varying the contract if third partyrights have been given. Therefore, the partiesto the underlying contract often reserve theright to rescind or vary the contract withoutreference to a third party benefitting from thirdparty rights.

3.6 Collateral warranties/thirdparty rights and latent defectsinsuranceIn the context of collateral warranties and thirdparty rights, it is relevant to mention latentdefects insurance policies (sometimes alsoreferred to as decennial insurance policies asthey tend to cover a building against defectsfor ten years from practical completion). It isnot possible, within this guidance note, to

review all the insurance policy options availablebut, in essence, a latent defects insurancepolicy is a non-cancellable policy covering thecost of rectifying certain types of defects thatmay arise in a building during a ten (orsometimes 12) year period following practicalcompletion. It would tend to cover, as insured,owners, tenants and certain other parties withan interest in the project (including funders).Such a policy is often put forward as analternative to collateral warranties and thirdparty rights and the terms (and cost) of thepolicy would have to be examined closely byinsurance specialists. However, even where alatent defects insurance policy is in place, it isoften the case that collateral warranties andthird party rights are still needed to cover anygaps that there may be in the extent of coverprovided.

3.7 Direct agreements – itemsfor consideration

3.7.1 Direct agreements are used mainly inpublic sector projects, such as PFI/PPP, butthey are sometimes used in more complexproperty development and other major projectsinvolving a government body. It will benecessary to establish in what circumstancesthe funder can step into the shoes of theemployer. Consideration should be given towhat the events of default in the contract are,and to what extent the employer is at risk ofdefaulting under the contract.

3.7.2 What power does the funder have oncethe step in has occurred? For example, do theyhave the power to administer the buildingcontract/sub-contract (or other relevantcontract) themselves, or solely to appointanother entity to do so?

3.7.3 Consideration should also be given tohow long the funder has to find a replacementbody, and what the specified standard is thatthe funder should follow when finding such abody. For example, does the funder have tofind a body with the same financial and,perhaps, technical standing as the originalemployer? Should any such body haveexperience of running similar projects? The


direct agreement will have a step in period,which is the time given to the funder to assesswhether it is worth rescuing the project throughtransferring the project by novation to anotherbody the funder controls or has an interest in.Consideration has to be given to how long thisperiod should be (e.g. 90-120 days is notuncommon in some PFI/PPP projects) and towhether the contractor is paid during thisperiod. It will normally be a condition to anyexercise of a step-in right that the funderundertakes to pay any amounts that are unpaidat the time the step-in rights are exercised andto discharge any future obligations owed to thecontractor which arise after that date duringthe step in period or after the contract hasbeen formally taken over. The direct agreementwill usually specify the grounds on which thecontractor can object to a proposedreplacement employer. The contractor will needto know that the proposed replacement hassufficient capacity (including financialresources) to perform the obligations arisingunder the contract.

3.8 Payment security methods– items for consideration

3.8.1 Escrow accounts(a) An escrow account is sometimes used in aconstruction project as security for paymentswhich an employer is to make to a contractorunder a building contract. This is because suchpayments are generally made in arrears.

(b) A contractor may be concerned about theability of the employer to make such paymentsand/or with its ability to recover unpaidamounts from the employer (e.g. because theemployer is not resident or has no assetswithin the UK).

(c) It will be necessary to review the status ofthe bank account into which escrow moniesare paid. Is the account in the joint names ofthe employer and the contractor? Is it in thenames of their lawyers (who might operate theescrow account as escrow agents on theirbehalf)?

(d) How much is to be paid into the escrowaccount and when are such payments to be

made? On a project that will take some time tocomplete, the parties may need to agree thatthe sum in the escrow can vary over time,either to reflect the highest likely payment levelor to reflect the reducing costs of the projectas it nears completion. Alternatively, the escrowaccount might be used to make all paymentsunder the building contract in which cashpayments into the escrow account can reflectan agreed cash flow schedule.

(e) What is the position of the contractor in theevent of the insolvency of the employer? Willthe contractor have a secured claim againstmonies in the escrow account or will suchmonies be in the general pot for the benefit ofall creditors of the employer? Are the moniesheld in the escrow account being held in trustin favour of the contractor? This is a detailedand complex area of law but if such monies aresubject to a trust then, in principle, thecontractor can call for payment from thataccount, despite the employer’s insolvency. Ifthere is no trust established in favour of thecontractor, the contractor is likely to have toprove along with the other creditors of theemployer on an equal basis in any insolvencyproceedings, to recover any sums owed to itby the insolvent employer. In most cases,where no trust is established, the contractorwill rank as an unsecured creditor in theemployer’s insolvency and may not be able torecover all or any of their debt.

(f) There are likely to be a series of documentsin place dealing with the escrow account andthe manner in which funds can be paid out ofsuch escrow account. These may consist of acontract that formalises the escrowarrangements between the parties and acontract with the party who is to operate theaccount – the escrow agent. The terms onwhich the escrow agent will operate theaccount will need to be reviewed carefully. It islikely that the agent will want to operate theaccount in a ‘mechanical’ manner, i.e. it willpay out only on receiving notices in the formscontained within the escrow agreement.

Care should be taken to ensure that the noticesare served using the correct method, containthe required information and are served on thecorrect person and address within the


prescribed timescales. These details are usuallyset out in the escrow agreement in addition tothe form of notice which should be used. Anamendment to the building contract may berequired, adjusting the payment terms to takeaccount of payments coming from the escrowaccount or the possibility that some paymentsmay come from the escrow account. There arelikely to be provisions dealing with the cost ofany significant change or variation to the workswhich might alter the cash flow schedule andrequire an adjustment to the sum being held inthe escrow account.

(g) The escrow arrangements will need to setout clearly how the monies in the escrowaccount, and any accrued interest, should bepaid out in all conceivable circumstances, evenif the project is stopped or abandoned. Itshould also deal with who pays for the cost ofrunning the account and set out how disputesshould be dealt with.

(h) In relation to the building contractamendments (if required), there may be furtheramendments that need to be made dependingon the terms of the escrow arrangement. Forexample, in the event that either party wants tosuspend the performance of its obligationsunder the building contract for non-payment,the building contract may need to be amendedso that non-payment into/from the escrowaccount is also included.

(i) Consideration should also be given towhether the escrow agreement will beconsidered a construction contract for thepurposes of the Housing Grants, Constructionand Regeneration Act 1996 (as amended) (theConstruction Act) and, therefore, whether itsprovisions conform to the terms of the Act. Thefull details and effect of the Construction Actare outside the scope of this guidance notebut, in general terms, the Act regulates, amongother things, how payment provisions must bestructured within a qualifying constructioncontract and provides for disputes to be dealtwith by way of adjudication.

3.8.2 Project bank accounts

(a) A project bank account is designed toincrease payment security and speed up

payment for contractors and others in theconstruction supply chain.

(b) In a typical example of a constructionproject, the parties set up a project bankaccount in the joint names of the employer andthe contractor. The intention is to adopt apayment mechanism under which parties in thesupply chain (including sub-contractors) receivepayment through a bank account operated inaccordance with the terms of an agreementbetween the relevant parties.

(c) The building contract should set out thesums that the employer has to pay into theproject bank account. Those payments shouldbe made as and when such monies becomedue in accordance with the terms of thebuilding contract. The intention is that thecontractor, sub-contractors and suppliers whoare parties to the project bank accountagreement are all paid on time and inaccordance with their relevant contracts.

(d) There is likely to be a restriction on theability of the account holders (who are likely tobe the employer and the main contractor) towithdraw monies from the project bankaccount (other than in the case of moniesproperly owed to the contractor). The moniesare usually held in trust for the benefit of thesupply chain in accordance with theircontractual entitlements.

(e) It would be common in project bankaccount arrangements to have regular (usuallymonthly) payments made into the account. Theaccount then reduces/empties as payments areauthorised to be made to the contractor, sub-contractors and suppliers.

(f) If an employer needs to pay less than theamount otherwise owing to the contractorunder the building contract, they should issuethe appropriate notices required under thecontract in the usual way. Care should be takento ensure that the notices are served using thecorrect method, contain the requiredinformation and are served on the correctperson and address, and within the prescribedtimescales. These details are usually set out inthe building contract (or, if not set out there,are usually prescribed by default by theConstruction Act ). Project bank accounts do


not cut across existing contractual or statutoryobligations or entitlements.

(g) As and when new sub-contractors areappointed by a contractor after the date of anyproject bank account agreement, and it isagreed that such sub-contractor should be anadditional party, it will be necessary todocument that position. This will usually be byway of a simple ‘additional party’ deed.Similarly, if a sub-contractor is removed orceases to be involved, that sub-contractorshould cease to have any further interest in theproject bank account.

(h) The relevant project bank accountagreement should be reviewed to establishwhether the benefit of the agreement isassignable by any of the parties to anotherparty.

(i) Consideration should be given to when theproject bank account agreement terminatesand in what circumstances. Is the agreementlive until all payments have been made underthe project contracts; will it determine if theemployment of the contractor under thebuilding contract determines; can the partiesagree that it determines, and so on?

(j) Establish the position on interest payable onthe amounts deposited in a project bankaccount. Who takes the benefit of such interest

and in what circumstances? Often the interestcan be used to offset bank charges.

(k) The list of sub-contractors who will take thebenefit of a project bank account arrangementwill have to be agreed for inclusion in thebuilding contract (having regard to themechanism for adding sub-contractors referredto at 3.8.2(g)).

(l) As discussed at paragraph 3.8.1(e), in thecontext of a creation of a trust over monies inan escrow account, similar principles apply inrelation to a project bank account. In short,while this is a complex area, if the balance of aproject bank account is subject to a trust infavour of the contractor and sub-contractorsthen, in principle, the contractor and sub-contractors can call for payment from thataccount despite the insolvency of the employer.This should mean that the contractor’s andsub-contractors’ claims in such an insolvencywill be over the amounts owed to them underthe building contract and sub-contracts (or pro-rata if there are insufficient monies to pay themall within the account) and these claims shouldrank in ‘priority’ to claims from unsecuredcreditors of the employer.

(m) Both the JCT and NEC publish projectbank account materials for use with theirrespective contracts.


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RICS Professional Guidance, UK

1st edition, guidance note

GN 101 /2013

Construction security andperformance documents

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